Likely Beneficiaries of Heavy Oil Production Technologies: Schlumberger, Imperial Oil

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Includes: BHGE, HAL, IMO, SLB
by: Randy Kirk, CFA

Heavy oil accounts for more than double the resources of conventional oil, according to Schlumberger (NYSE:SLB). Most of the current and historical oil production has come from conventional reservoirs, which contain oil that is sufficiently viscous to be pumped utilizing well pressure and non-specialized pumps. Heavy oil is more viscous (thicker, like molasses) than conventional oil so is much more difficult to extract from the ground. Currently, the volume of heavy oil production is currently only a fraction of the production from conventional oil. However, going forward, it is almost certain that the world's dependence on heavy oil production will increase due to the massive resource base of heavy oil and projected increased demand from Asian and developing countries.


Source: Schlumberger

There are several methods of heavy oil extraction currently, but, as the heavy oil industry is still in its beginning stages, there is not a de facto "standard" of heavy oil extraction for the industry -- one that is low cost and efficient, that can be applied across most heavy oil deposits. The question that is most relevant for investors is: will there be a dominant, patented technology for the development of heavy oil reserves? And secondly, if so, which firm will capture and patent this technology? These questions will be explored in this article.

Relevance of Proposed Heavy Oil Production Technologies to the Historical Success of Howard Hughes, Sr:

There is (in the author's mind) a relevant comparison of the new technologies for the development of heavy oil to the historical example of Howard Hughes, Sr, who made his fortune mainly by inventing and patenting a drill bit that could drill through hard rock, which was, in turn, utilized by the majority of the oil industry to develop conventional oil reserves. Hughes Sr's drill bit became the foundation for Hughes Tool company which later merged to become the oil services firm Baker Hughes (BHI). Hughes Sr. patented drill bit design was so profitable and necessary for the development of conventional oil reserves that Daniel Yergin, writing in his epic book "The Prize" described Hughes' pricing leverage as "highway robbery." This article will explore if there is a similar technology, such as Howard Hughes Sr's patented drill bit, that is applicable to heavy oil extraction.

Background on the Heavy Oil Industry:

The interested reader is encouraged to read the heavy oil sections of Rigzone and wikipedia, as well as Schlumberger's excellent heavy oil website for a background to this very important topic of heavy oil. A brief discussion and summary of heavy oil is presented as follows. The majority of heavy oil deposits are found in two countries, Canada -- in its Albertan oil sands, and Venezuela -- in its Orinoco belt -- both of which contain reserves of recoverable oil comparable to those of Saudi Arabia. Approximately 90% of heavy oil is found in the Western Hemisphere -- mainly in Canada and Venezuela, although significant deposits exist in California, Alaska, Mexico and Brazil, as well as in Russia -- while 90% of conventional oil is found in the Eastern Hemisphere -- mainly in the Middle East. Most of both heavy oil deposits in Canada and Venezuela are underground, below where they can be mined by mining methods -- although approximately 10% of the surface area of the Albertan oil sands can be mined (and this area is already nearly 100% leased by firms, as I discussed in my earlier Canadian oil sands article). The Venezuelan heavy oil deposits are a bit more viscous -- able to flow more easily -- than the majority of the Canadian oil sands -- and therefore, so far, different and methods have been used to extract Venezuelan heavy oil deposits than the Canadian oil sands deposits.

Oil Sands Carbonates:

Note that approximately 50% of the Albertan Oil sands by area are in the form of carbonates, which means the oil sands are trapped in rocks, in a similar way to oil shale. The carbonate formation forms a "triangle" in geographic terms across the Canadian heavy oil deposits. The carbonates require different technologies for extraction than traditional heavy oil, as will be discussed below.

Source: Geological Survey of Canada

Heavy Oil Extraction Technologies in Usage Currently:

There are 5 main technologies currently in operation in the heavy oil industry for the development of traditional heavy oil (not heavy oil carbonates), with varying cost efficiencies and recoverability factors: Cold Heavy Oil Production with Sand, Steam Assisted Gravity Drainage, Mining, Cyclic Steam Stimulation, and Vapor Extraction. Note that most of the techniques were pioneered in Canada due to Canada's relatively early development of its Albertan Oil Sands. These technologies are described briefly as follows.

1. Cold Heavy Oil Production with Sand [CHOPs] -- this technique utilizes a submersible pump that can pump thick fluids, down to the heavy oil and pumps from there, allowing sand and other rocks up the wellbore -- as it is difficult to separate out the sand from the heavy oil. CHOPs is usually utilized without additional heating or chemical treatment. As such, it can be considered the most simple extraction method for heavy oil that is deep below the surface. It is believed the majority of Venezuela's heavy oil is produced using CHOPs. (Venezuela produced an estimated 625,000 barrels per day of heavy oil in 2006 through its national oil company, PDVSA.)

- CHOPs Advantages: Straightforward, relatively simple production method, continuous production, cost effective if heavy oil is viscous enough (as in Venezuela)

- CHOPs Disadvantages: Inefficient if the heavy oil is too thick (as in many areas of Canada), expensive to maintain and/or replace specialized submersible pumps, estimated only 5-10% of total heavy in place can be recovered with CHOPs, "technology stretched to the limits" according to Schlumberger so low future productivity improvements likely possible

2. Steam Assisted Gravity Drainage [SAGD] -- this method of heavy oil extraction involves melting the heavy oil with steam, then collecting the melted heavy oil by vents. A video demonstration of SAGD can be found at Rigzone. Imperial Oil (NYSEMKT:IMO) of Canada (majority owned by Exxon Mobile (NYSE:XOM)) has done much of the pioneering work on SAGD in its Canadian Oil Sands properties, and is the largest producer of heavy oil by SAGD methods currently. According to Imperial, SAGD works well when the heavy oil is able to move vertically with relative ease (in petroleum geology terms, "good vertical permeability") -- therefore the usage of SAGD depends on the underground geological conditions of the heavy oil resource.

- SAGD Advantages: Continuous production, technology able to cost effectively access less viscous heavy oil (bitumen), room for efficiency improvement in process

- SAGD Disadvantages: Concerns over CO2 emissions and water usage [although water can and is recycled], uses natural gas (to heat the water into steam), relatively low recovery rate of oil in place of less than 50% [but future improvements of recovery rate are possible according to Imperial Oil], mainly only applicable to heavy oil reservoirs of at least 40 meters thick

3. Mining Methods -- this technique involves digging the oil sands which are available near the surface and transporting the heavy oil to processing facilities. The majority of the Canadian oil sands currently (12.07) are produced in using this method, although heavy oil produced in Canada by in situ methods is increasing. Suncor and Syncrude are by far the largest producers of oil sands in Alberta by mining methods, although Imperial Oil has new mining projects coming on line.

- Mining Method Advantages: Proven, cost effective with efficient use of equipment, straightforward to increase production, recovery rate 80-90% of heavy oil in place

- Mining Method Disadvantages: concerns over CO2 usages, heavy equipment and labor intensive, only a small amount of heavy oil sands can be produced by mining methods, possible concerns over environmental damage

4. Cyclic Steam Stimulation [CCS] -- this technology involves a multi-step process of first, steam injection, then a period of up to several weeks of steam "soaking" (heavy oil mixing with the steam), then a period of recovery of the melted heavy oil. This technology is demonstrated in video format at Rigzone. Imperial Oil was the pioneer of this technology, and holds patients with regards to usage of CCS. CCS is an older technology than SAGD, but still produces a majority of its "Cold Lake" operations using CCS due to geological considerations at Cold Lake (Cold Lake is Imperial Oil's largest in situ producing region). In theory, SAGD is the more efficient technology due to the fact that heavy oil recovery is continuous and, further, SAGD is newer, but CCS is more efficient than SAGD in geological formations in which the oil can move relatively easily horizontally (good "horizontal permeability"), according to Imperial. Imperial Oil also announced an improvement to CCS in 2007, which involves adding a hydrocarbon solvent to the bitumen to improve efficiency and recoverability, and is now using this solvent in its operations.

- CSS Advantages: Cost effective, applicable to heaviest grades of bitumen

- CSS Disadvantages: CO2 and water intensive [although water can be recycled], heavy oil is only collected periodically, not continuously, recovery rate is somewhat low at 15-20% [but possible to improve according to Imperial Oil], mainly only appilcable to heavy oil reservoirs of 40 meters thick and above

5. Vapor Extraction [VAPEX] -- VAPEX involves injecting the in situ heavy oil with chemicals, CO2 and/or hydrocarbons, in order to make the heavy oil more viscous -- and cut down on water, energy usage and pollution -- which can then be extracted efficiently, and possibly also improve total oil recovery rates. A video demonstration of VAPEX can be found at Rigzone. According to the technology editor of worldoil.com, VAPEX is the most promising of the new in situ heavy oil production technologies, although it has not been utilized on a large scale yet. In theory, VAPEX can be combined with SAGD and/or CCS above, and, in fact, Imperial Oil has started utilizing a hydrocarbon solvent to improve efficiency in its Cold Lake operations in 2007.

- VAPEX Advantages: Possible higher recovery rates, efficiency and less pollution than other above methods, applicable to all grades of heavy oil

- VAPEX Disadvantages: compared to other methods, relatively untested, some combinations of solvents will probably not work so possibly expensive to carry out trials of method technology

Future Heavy Oil Technologies Proposed:

These technologies for the extraction of heavy oil have been proposed but have not undergone significant field testing, on the scale of the five technologies listed above, as of late 2007:

1. In situ combustion: proposed by both India's Oil and Gas Corp and the independent firm Petrobank, this technology involves "burning" the heavy oil underground and using the heat and the force of the combustion to move oil and gas through collection vents. Petrobank provides an overview and video demonstration of its in situ combustion "THAI" technology on its website. A few years ago, in situ combustion was viewed with skepticism by heavy oil insiders such as Schlumberger, who considered in situ to be undesirable due to the fact that it does not leave oil for future recovery (combustion rates of the total oil resource were thought at first to be high), and, further, in situ combustion did not have a large number of successful demonstrated successes (the oil industry tends to be conservative and new technologies face an uphill battle). Further, many industry insiders scoffed at the notion that the oil could be "upgraded" underground -- upgraded meaning shortening the hydrocarbon chains -- which is what the in situ production proponents were proposing that combustion could do.

However, in situ combustion has fared well on several small scale trials as reported by Schlumberger's heavyoil.com. Recovery rates have been shown at 80%, with less than 10% of the total resource consumed in the combustion flood, while some upgrading of heavy oil resource as been shown. Start up costs are about half that of SAGD according to Petrobank. Petrobank stated that it expects its THAI to be economical up to $30 per barrel of oil. Perhaps most impressively, the in situ combustion proposes to make the production of heavy oil resources with less than 40 meters thickness economic -- Imperial Oil's SAGD and CCS are only economic at 40 meters and greater resource thickness levels. There are many areas in which the heavy oil resource is only 20 or 10 meters thick, which means in situ combustion could have a large number of applicable areas. So far, the trials have not produced more than 1,000 bpd per well, and the temperatures for larger production may be difficult to control, as temperatures at the 1,000 bpd well in small scale trials ranged between 400 degrees C and a very high 1,000 degrees C. Further, it is critical in in situ combustion to understand in detail the geological characteristics of the resource through seismic and survey data, before the beginning of the procedure, as the procedure is mainly “one time through” – one movement of the combustion wall through the reservoir as the resource is burned. Operators also have a negative memory associated with in situ combustion stemming from failures in California in the 1970's (Petrobank insists that these failures have been fixed with the new method). With SAGD, It is likely many more trials will be needed before in situ combustion becomes a major new producing technology, but the possibilities are certainly intriguing.

- In Situ Combustion Advantages: Relatively low start up costs, higher recovery rates than SAGD in trials, less water and natural gas used than SAGD, partial upgrading of heavy oil resource, utilization of under 40 meters thick heavy oil resource

- In Situ Combustion Disadvantages: "one time through only" -- resource will be produced fully and no further extraction by other methods is possible after utilization, unproven application to large deposits, unproven scalability, possible difficulty in controlling fire flood across larger reservoirs

2. Electricity and Microwave Heating -- Two smaller firms (to the author's knowledge) have proposed electromagnetic radiation and electric heating of the bitumen for improved recovery -- Global Resource Corporation (microwave technology) and E-T Energy Ltd (electric heating of the oil sands). Only E-T Energy has initiated a trial of its technology -- with moderately successful results, as recounted on its homepage. E-T Energy estimates that 500 MW would be necessary to successfully produce 120,000 bpd of oil in the Albertan oil sands. Depending on the excess supply of power in the area, E-T Energy's technology likely has applications. Global Resource Corporation -- whose propriety technology consists of altering the frequency of the microwave in order to optimally heat certain substances -- is focusing mainly currently on microwaving used tires to produce carbon black, gas and synthetic oil -- so thus has been somewhat distracted in the near to medium term on a trial for microwaving oil sands. (note that Global Resource Corporation is currently a very small company, with less than $1M of assets on its balance sheet according to its latest 10-Q). A trial is likely a few years away for Global on microwaving oil sands. In theory, however, the microwave technology appears more efficient than passing simple electric current through the oil sands, so perhaps E-T Energy, or another heavy oil firm who wants to heat the oil sands would be interested in Global's microwave technology -- but at this point both technologies are in the theoretical stage.

Will there be a dominant oil sands production technology?

Taking in the lessons learned from the above survey, perhaps a more appropriate question than the above is: which technology will be the most profitable for underground deposits going forward? That is, when one asks, "Will there be a Howard Hughes of the heavy oil industry," one is mainly referring to technologies to develop underground heavy oil deposits, due to the fact that mining methods are firmly entrenched as the technology of choice for extraction of heavy oil deposits near the surface.

Imperial Oil is Well Positioned in the Heavy Oil Industry:

Much of the choice for the extraction technology depends on the characteristics of the underground heavy oil resource. For large (over 40 meter in thickness) non-carbonate deposits, it is the author's opinion that some combination of VAPEX and SAGD or CSS will be the most effective method, which would benefit Imperial Oil, which has patents on all three processes. Note also SAGD and CSS need capping shale, but preliminary geological data show that only 10% of Albertan non-carbonate oil sands lack capping shale. It is tentatively concluded that the majority of underground heavy oil is appropriately produced using Imperial Oil's technology. As noted above, Imperial Oil is the oldest producer of heavy oil and the largest currently, and therefore it makes sense that Imperial should have the most proven expertise with heavy oil extraction technologies. Imperial oil is not expensive currently at 15x earnings and a $45Bn market capitalization, which makes IMO an intriguing long term buy based on its heavy oil potential. Winner: Imperial Oil.

Heavy Oil Service Firms:

Schlumberger (SLB), and to a lesser extent, Halliburton (NYSE:HAL), stand to benefit greatly from the coming heavy oil boom. All the in situ technologies are optimized by extensive 3-D mapping, resource characterization and understanding of the resource, in which both Schlumberger and Halliburton have world leading technologies. Further, most in-situ technologies require submersible pumps, which Schlumberger is the world leader in terms of technology (the submersible pump industry is a good subject for another post, but in summary, Schlumberger makes world-class, technologically advanced oil pumps). However, Schlumberger is already slightly pricey currently at 23x earnings -- but is a buy candidate based on its heavy oil potential if the stock drops further.

Notes on Firms with In Situ Combustion Technology:

Petrobank is a higher risk, high return play -- the stock has already increased 250% this year, and now boasts a 100x p/e ratio and a market capitalization closing in on $4.0Bn. If the author was forced to predict the future viability of the in-situ combustion process, the author would say that it will find short term success in heavy oil resources that are not viable by other means -- so this would include heavy oil seams of under 40 meters. Most likely the customers of the Petrobank's process will be smaller companies -- and of course Petrobank itself, as it has its own oil sands territory -- with more less attractive lease areas of the Albertan oil sands. It is unclear if Petrobank will be successful in Venezuela, because Venezuela is negotiating heavy oil in situ combustion agreements with India's Oil and Natural Gas Corp -- which boasts an in situ combustion technology similar to Petrobank's technology. Further, Petrobank's technology is likely not applicable to heavy oil deposits which exist in permafrost, in the far North, due to the fact that the high heat generated will destabilize the permafrost and the heavy oil deposit. In situ combustion is also most likely not applicable to oil sands carbonates, due to the high concentration of rock with the heavy oil (so a fire flood would not likely be able to be generated). But there are still many areas around the world that would be interested in a relatively low set-up cost production method with high recoverability factors.

Oil Sands Carbonates Production:

One firm (that the author is aware of) has proposed and is in the process of implementing a production technology for heavy oil from oil sands carbonates -- OSUM Oil Sands Corporation. The 100% privately held OSUM is proposing an underground collection method that would heat the oil sands carbonates (carbonates are, as described above, heavy oil trapped in rocks) above a long tunnel, then collect the melted bitumen below in the tunnel and pump the heavy oil to the surface. Most of the work force would be underground leaving a low environmental footprint on the surface. OSUM is proposing to use steam to heat the bitumen, although it is possible they could be interested in other heating methods (microwaves, electricity) in the future. The first production trials are set for 2008, with full production of up to 100,000 bpd thereafter. This underground method looks quite promising for the production of oil sands carbonates, but unfortunately most investors cannot participate as OSUM is 100% privately owned.

Political Issues Concerning Heavy Oil in Venezuela:

Note that it is difficult to see foreign firms making tremendous profits in Venezuela under the current (Hugo Chavez) administration. Schlumberger is working on Venezuelan heavy oil, but Total -- which had developed Venezuelan oil sands -- was kicked out of the country in 2002 and replaced with PDSVA without significant compensation. The heavy oil resource is huge but it is the author's opinion that firms with appropriate technology catered to the specific geological characteristics of the Orinco belt face very significant political obstacles. The same rule also applies to firms operating in Russia. This also limits the overall profit potential for a firm such as Imperial Oil, which may have the best technology -- its market is Canada and other politically safe countries first and Venezuela a distant second.

Conclusion:

This article has discussed the current and emergent technologies for the production of heavy oil. It is concluded that, due to the wide range of heavy oil deposits, several technologies will be very useful in the future, and allow for high profitability to the designers and executers of these technologies -- including VAPEX, SAGD and CSS, as well as in situ combustion. These technologies point to future profitability for Imperial Oil and, for a higher risk, higher return play, Petrobank. Also noted was the fact that Schlumberger should see its share of profits from its expertise in servicing the heavy oil industry. However, it should be noted that it is possible that a certain up and coming technology has been missed by the author which could revolutionize the heavy oil industry. Further, auxiliary technologies, such as steam production equipment, carbon trapping and water recycling equipment, which are necessary for the production of heavy oil but not directly addressed by the main heavy oil production technologies, was not addressed in this article and is an important subject for a future article.

Disclosure: The author holds a long position in Imperial Oil